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Why China Is So Alluring

China has attracted vast amounts of foreign direct investment lately. In 2003, the Middle Kingdom was second only to the U.S. as a recipient of FDI. And inflows could soar in 2004 if the dollar keeps falling. First Eastern Investment Group, a Hong Kong private-equity business, says investment inflows could hit $100 billion this year (chart). However, "a further 20% fall in the dollar could send FDI as high as $150 billion this year and next," says First Eastern Chairman and CEO Vincent L.L. Chu.

Because the yuan is now pegged to the greenback, investors from Japan and Europe find Chinese assets more attractive as the dollar falls against the yen and euro. A weak U.S. currency also makes Chinese goods more competitive in Europe and Japan, which boosts exports, corporate earnings, and thus the returns on Chinese investments.

At first glance, Chu's estimate looks excessive: The $53.5 billion total for 2003 fell short of Beijing's $57 billion FDI target. But experts pin the shortfall on investor concern over SARS. Once those fears eased, FDI took off again, up by an annualized 24% in December. Contracted FDI, an indicator of future trends, totaled $10.2 billion in January alone, up 10.4% from a year ago. Chinese Commerce Ministry officials say that if the dollar doesn't fall, investment into China could still rise by 30% this year. Such a large inflow of funds would add stress to China's shaky financial system and raise fears of economic overheating.

Now is an especially good time to put money into China. Government officials are committing themselves to making the yuan's exchange rate more flexible, possibly this year. A revaluation would effectively cause the yuan to strengthen against the dollar, automatically lifting the value of Chinese assets already held by overseas investors.

China's gain could be its neighbors' pain. Thailand, Vietnam, and other Asian emerging markets complain that China gets more than its share of FDI. However, these nations will gain if they can lure more investment from Chinese businesses now beginning to invest abroad. Those companies shelled out a mere $2 billion in FDI last year. But given the country's booming economy, that sum should increase, especially if a stronger yuan makes overseas assets cheaper for Chinese investors. In the U.S., banks hardly noticed the last recession. Indeed, banks' return on equity was higher than 12% during the 2001 recession, vs. a 7.7% return in the 1990-91 downturn, when the fallout from real estate and foreign debt hurt earnings. Til Schuermann, a senior economist at the Federal Reserve Bank of New York, studied the industry to explain its strength in this business cycle. His conclusion: "Improved performance stems in large part from better risk management on the part of banks."

Take the consumer sector. In the mid-'90s, retail lenders eschewed a uniform rate, or so-called house rate, for products such as credit cards. Instead, they linked lending rates to a person's credit risk. That move allowed banks to begin accepting riskier borrowers.

By charging rates based on risk, lenders could do a better job of forecasting losses. Charge-offs -- bad loans as a share of loans outstanding -- rose as high as 4.12% at the end of the last downturn, vs. 2.3% after the 1990-91 recession. But banks were prepared for the increase, allowing them to remain profitable, says Schuermann.

Also, interest rates charged to riskier corporate borrowers in the syndicated loan market rose faster than rates for more creditworthy businesses. And once the loans were on the books, lenders cut their risk by buying derivatives.

To be sure, the 2001 downturn was mild, and the Fed kept banks' cost of funds low. But improved risk management shouldn't be underestimated. By better judging risk, bank resources can be more efficiently distributed to a more diverse field of customers. That leads to greater financial and economic stability. Unemployment, at 5.6% in January, has fallen from 6.3% in June, 2003. But that's not because of robust job growth. Instead, many younger Americans have dropped out of the labor force.

Since March, 2001, a total of 408,000 Americans aged 16-24 have left the workforce -- meaning they are neither employed nor actively trying to find a job. The labor-force participation rate -- the share of those 16-to-24-year-olds with a job or looking for work -- hit a 32-year low of 60.5% in December, accounting for the entire fall in the overall participation rate (chart).

It appears that many headed back to school. The latest data, through 2002, from the U.S. Census Bureau show that the share of 18-to-24-year-olds in college declined from 1998 to 2000 but resumed an upward trend after the recession began.

What if the drop-off hadn't occurred? If young people's participation rate were equal to its level in March, 2001, the unemployment rate could be 6.6%.

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